As an investor, navigating the nuances of the investment industry can be quite challenging especially as human emotions, such as the fear of missing out, are often involved. It isn’t surprising, then, that the sole criteria when selecting an investment often ends up being its one- or two-year return.
Exchange-traded fund (ETF) providers and active fund managers know this all too well and therefore incubate new funds based on the market’s flavour of the month, and then excessively promote those that have delivered strong near-term returns. Investment advisors/ managers, many of whom are still compensated for selling specific financial products, also know that those in the spotlight sell particularly well.
In today’s market environment, the hot sectors include marijuana, robotics, automation and artificial intelligence, cryptocurrencies and even certain segments of the U.S. market, such as the FAANG (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) stocks, which have been the primary drivers of the S&P 500’s recent returns.
As an independent investment management firm, we prefer a more data-driven balanced approach which takes away some of the speculative return-chasing from the investment process. We’ve learned over the years that when selecting asset managers, including both long-only alpha generators and specialised alternative managers, there are three key factors to look for if you are more interested in the fundamentals and strategic portfolio fit instead of simple near-term performance.
Determining the Needs of the Investor
This first part may seem a bit counter-intuitive, but before you can evaluate an asset manager, you need to know exactly what the investor’s needs are. How else can you determine whether the asset manager has a solid chance of meeting these needs? Of course, advisors won’t seek a new asset manager for each and every client, and we recognise advisors often have a few “go to” asset managers that are appropriate for common situations. But, when selecting an asset manager to put into a new or old portfolio, we need to start with some of the basics:
- What are the investor’s goals?
- Are there constraints or preferences to the geography of the investment?
- Does the investor have maximum volatility or drawdown expectations?
- Are their income needs required from the investments?
- Are any of the answers to the above restrictive or can the investment be unconstrained or tactical?
- What returns are needed over time to meet the investor’s goals?
In our opinion, the answer to this last question should become the benchmark for the investment. If an investor understands that their portfolio only needs to take on the risk and reward characteristics needed for them to achieve their goals, then we can dispense with the tomfoolery of using an arbitrary index which has no tieback to the investor, their goals, or their true investing success.
Selecting the Appropriate Benchmark
Choosing an appropriate benchmark is essential for providing investors a baseline for evaluating an asset manager’s success over the long-term. An inappropriate benchmark can make a skilled manager look ineffective or an under-performing manager look capable. However, choosing the right benchmark is subjective and not always straight-forward—it requires careful consideration between the asset owner and investment manager. Generally, a benchmark should be:
- Transparent — the names and weights of individual investments are clearly known,
- Investable — investors have the option to forgo active management and passively approximate the benchmark,
- Measurable — the performance can be calculated on a frequent basis,
- Appropriate — investment style is consistent with the portfolio being measured,
- Specified in advance — the benchmark is selected prior to the beginning of an evaluation period,
- Understandable — investors (and participants) should readily understand the benchmark and its components
- Public — investors (and participants) should be able to verify performance using third‐party data.
When assessing the success of an asset manager’s performance, it is important to consider whether the asset manager has chosen an appropriate performance benchmark. They must select a benchmark that accurately represents the asset manager’s investment strategy—even though it may be more challenging to demonstrate success.
Selecting an Asset Manager
If you have decided that an asset manager is appropriate for you, consider the following to select one that best suits your needs.
Asset Management Firm – Each firm’s profile is different, with its own history, ownership, size and profile. Firms manage money in different ways and offer an array of products. Some specialise in types of clients. The key to selecting the right firm is to ensure they are licensed, and they fit your personal circumstances.
People – Asset management performs two functions: client relations to ascertain needs and managing investments. In large firms, these roles are performed by different professionals. Most asset managers hold the coveted Chartered Financial Analyst designation (CFA charter), which is the most respected and recognised investment credential in the world.
Philosophy & Style – Asset managers use different investment management approaches and styles. Some managers are product specialists, some adopt a certain style such as value, growth or momentum, and some offer a combination of products and styles.
Compensation – Nothing will motivate a manager’s performance more than his own bottom line. Make sure the manager’s compensation is tied to outperforming the benchmark because this is what you’re paying them for. Another encouraging sign to look out for is that some managers also will invest their own money in the fund. You’ll find a manager’s compensation and level of investment in the fund listed in the prospectus.
The key thing to look for in the asset manager selection process is a sound and disciplined investment philosophy. The next thing to review is the investment process, particularly security selection. Things should be understandable and reasonably simple. If you can’t understand it, the manager probably doesn’t. A historical track record is only evidence of skill. A proper manager search will establish whether the historical performance is skill or luck.